This Easter one of my brother-in-laws asked what I was investing in. My response was “inverse volatility.” I might as well have said pixie dust. I stood there wondering where (or if) to start. First you have stocks, then you have the S&P 500, then you options on the S&P 500, then you have implied volatility calculations, then you have futures on volatility, then you have ETNs with rolling mixtures of futures on volatilty (VXX), and then you have the inverse (or the short) of that. We looked each other in the eye and wordlessly agreed that we wouldn’t start.

I like inverse VXX/VXZ investing. It’s seldom boring and over the long run the advantage is on your side. Volatility has a return to mean behavior, and volatility futures are almost always in contango—which erodes the value of VXX. If you buy inverse volatility when the VIX is relatively high, your chances of making a good profit eventually are very good.

So when he mentions the contango of VXX, is he suggesting that XIV really makes its money shorting decay?

Unfortunately it’s not possible to directly invest in the VIX, so the next best solution is to invest in VIX futures. This “next best” solution turns out to be truly horrible—with average losses of 5% per month. [....]

This situation sounds like a short sellers dream, but VIX futures occasionally go on a tear, turning the short sellers’ world into something Dante would appreciate.

Six Figure Investing - IVOP and XIV and termination events. One of the things I've been saying is there has to be some massive drawback to buying XIV, or else the market would abandon stocks entirely and just short volatility. Money is supposed to maximize return, right? In this article the author points out that XIV gets liquidated on a big drop. That, to me, is one scary frickin' risk. Quote:

With XIV termination (or “acceleration” in marketing speak) relates to daily percentage moves. If VXX jumped more than 100% in a day, then if VelocityShares didn’t terminate XIV its notational value could go to zero. They avoid this particular unhappy situation by terminating the fund if the daily move of VXX is 80% or more—although losing 80% in one day would still be plenty traumatic.

Just to be clear, these funds aren’t tied directly to VXX, but rather the underlying futures contracts, but I believe VXX is a good proxy for the situation.

The termination risk for XIV appears to be limited to market crashes worse than the Flash crash. Two examples that come to mind are the 2009 crash and the October 1987 crash. VXX didn’t exist for either of these. I have analyzed VIX data (or simulated data) since 1992—there were 20 days with VIX jumping over 30% (previous day close to intraday high) during that period. The highest percentage jump over that period was 70.5% on February 27, 2007. There were three days with VIX jumps over 30% in the 2008/2009 crash, and during the Flash Crash.

So I guess we can put a big red star beside "liquidation" as a significant "you won't ever sleep again, and good luck finding a therapist that'll take you" downside. I've been reading the HVI prospectus and haven't seen any direct mention of this provision there, but as noted above (if HVI is structured the same as XIV, which it seems like given how well it tracks XIV) the notional can still drop to below zero on a >100% daily VIX jump if there is no liquidation provision; so Horizons must still have one. Scary.

Six Figure Investing - under the hood of XIV: cause for concern. Two years ago he expressed the same fear that I did more recently: the massive influx of new capital into the inverse-VIX ETFs might just be moving the market. After all, you're shorting the premium on downside protection, which makes downside protection cheaper, which makes it easier for others to hedge, which might make the market levitate up faster than it should. XIV essentially causes $VIX to give the market a false signal, and we all know how much of the market is being run by algos nowadays.

Then again, if XIV only has $670M in it right now, that's not much in comparison to the total size of the futures market, right? So maybe we don't have to worry until the day that everyone's gone short $VIX: at that point one little wobble in equities will wipe out the market like Chicxulub wiped out the dinosaurs.